"SPEEDING UP SETTLEMENT: THE NEXT FRONTIER"
REMARKS BY CHAIRMAN ARTHUR LEVITT
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
SYMPOSIUM ON RISK REDUCTION IN PAYMENTS,
CLEARANCE AND SETTLEMENT SYSTEMS
THE PIERRE HOTEL, NEW YORK
JANUARY 26, 1996
This conference brings together many people with first hand
experience in managing clearance, settlement, and payment system
crises. Jerry Corrigan presided at the Federal Reserve Bank of New
York during the October 1987 market break and the demise of Drexel
Burnham Lambert. John Corzine was part of the team at Goldman
Sachs that helped resolve the gridlock that overtook the mortgage-
backed securities markets immediately following the insolvency of
Drexel.
I've had my own experiences with settlement questions -- which
is often a euphemism for "settlement crises."
As a brokerage firm executive during the 1960s and 1970s, like
all my colleagues, I had to meet the multiple challenges of new
technology, wildly fluctuating trading volume, and new-found
competition following the "unfixing" of commission rates in 1975.
We weathered the paperwork crisis, and learned first-hand how
important back office systems are to the well-being of both firms
and markets.
As Chairman of the American Stock Exchange, I worked to apply
technology so that investors could trade with confidence,
especially during periods of high volume and price volatility, such
as the market break of October 1987.
And as Chairman of the Securities and Exchange Commission, it
has been my goal to have the markets settle their trades faster,
in three business days instead of five.
One of the first lessons I learned as a brokerage executive
was that huge numbers of people and firms are involved in making
payments, clearance, and settlement systems work. They rely on
a dedicated core of exchanges, clearing agencies, and hundreds of
banks, brokerage firms, and companies. Their degree of
interdependence can be staggering. But this also means that such
systems are only as strong as their weakest link -- so any attempt
to strengthen the chain must strengthen every link.
Over the years, I've come to believe that payments, clearance,
and settlement systems are the real backbone of our securities
markets. They must be strong, resilient, and flexible.
A flexible settlement system is especially important in this
country because of our widespread participation in the market.
With more than 51 million individual shareholders, the US has a
constant and compelling need to maintain individual investor access
to its markets. Our settlement system must accomodate the needs
of those investors, not try to force them to conform to the
system's needs. Settlement systems also play a huge role in
maintaining confidence in the market -- investors want to know that
their trades will be completed on time, that they won't lose their
funds or securities because of insolvent firms, and that the
markets will be open if and when they want to buy or sell.
I arrived at the SEC in 1993 with a firm commitment to reduce
risk in our markets. The primary tool available to us was to speed
up settlement -- indeed, The Bachman Task Force Report, published
the year before, had suggested that three-day settlement would
reduce the credit and market risks to the intermediaries clearing
securities by as much as 58%. This was the prelude to T+3, which
required that standard trades in most securities be settled in
three business days, as opposed to the previous standard of five.
This was the first reduction in settlement times this century
and it brings us back to the time frame that was prevalent at the
time of the Korean War. Although we did this for many worthy
reasons -- to reduce credit exposure in securities markets, to
bolster investor confidence, to add greater discipline to the
process, and so on -- we faced some opposition from almost every
quarter: from brokerage firms, from banks, and of course from
individual investors. Whether in town meetings with individual
investors, or in conversations with industry executives, I was
questioned often about the benefits to be achieved. Investors
feared it would cut off their access to the securities markets,
while firms thought the costs -- in lost float, or compliance costs
-- would be too high.
More than 1,500 individuals took the time to write to the
Commission and Congress. Let me quote from just a few of the
letters we received:
* from a gentleman in Texas: "The new rule would seem to be an
effort to squeeze the small investor out of the market."
* from a couple in California: "You have seen to it to take
another freedom away from the small investor."
* from a woman in Kentucky: "Just whose bright idea was it to
institute the 3-day settlement requirement. . . ? Does
everyone in Washington spend their time thinking up ways to
make the lives of little people utterly miserable? Or is
there some element of collusion with the brokers in the U.S.
to force us to turn our securities over to them and to set up
money market accounts with them?"
* and from a couple in Maryland: "We question the need to
penalize the small investors for the sins of the big players."
Many investors told us their postal service war stories --
items sent but never received, letters that took weeks to reach
their destination -- and asserted that postal delays would
inevitably translate into failed settlements. Many objected
vehemently to establishing financial or asset management accounts
with their brokers and viewed the change as forcing them to engage
a host of lawyers, accountants, and professional managers.
The problem, of course, was that the benefits to the investor
-- increased liquidity, less systemic risk in their markets -- were
long-term, while the inconveniences were quite immediate. If I had
to do it all over again, I would invest even more effort in
communication with the public about the benefits of faster, more
reliable settlement -- and about how we all have to do our share
to strengthen America's markets. That's a lesson for the future.
Despite the criticism, the SEC rode on and implemented T+3.
Let me share with you a few observations drawn from settlement
statistics that, I think you'll agree, indicate that we made the
right decision and that the conversion went reasonably well.
Broker-dealers are settling more trades on-time among
themselves in three days than they did when settlements could be
completed in five days. As you know, the National Securities
Clearing Corporation's continuous net settlement system is where
most broker-dealers settle exchange or over-the-counter trades with
other broker-dealers, including exchange specialists and OTC market
makers. In May 1995, before T+3, and with average daily volume
running at 726 million shares in NYSE, Amex and Nasdaq securities,
NSCC "failures to deliver" were an average of 8.43% of all
deliveries. In November 1995, after the T+3 conversion, with
average daily volume running at 830 million shares in the same
securities, NSCC "failures to deliver" declined to 7.67%.
At the same time, broker-dealers appear to be settling about
the same percentage of institutional trades in three days as they
did in five. The percentage of trades authorized to be settled
between institutional investors and their broker-dealers has not
changed significantly, either -- it was 89% in November 1995 and
90% in May 1995. Obviously, more can and should be done to speed
up the process by which the various agents for an institution --
the investment manager, the brokerage firm, and the securities
custodian -- go about arranging for the movement of funds and
securities.
I have heard anecdotally, however, that T+3 has meant that
more people know what their positions are on the trade date and,
as a consequence, are less likely to renege on their trades. Fund
and investment managers no longer have the luxury of waiting until
T+1 or T+2 to book trades "as of" trade date. Similarly, it's now
possible for customers executing trades to find out on trade date
the net cost of their trades -- something that was not always
possible before T+3.
In an ideal world, we could reduce risks by shrinking
settlement periods further, even as far as same-day settlement.
That's the settlement cycle for commercial paper, and faster than
the current cycle for trades in US Treasury bonds, bills, and
notes. "T+0" would have many advantages:
* Faster settlement would further reduce the risk of loss to
investors and intermediaries from the insolvency of other
market participants.
* Same-day settlement would require market participants to "pre-
position" their assets and, if the transaction involved an
extension of credit, to arrange for that credit at or before
the time a trade was placed. This would reduce "fails" by
several more percentage points. In such an environment,
people trading in the market could be extremely confident that
settlement would take place.
* Faster trade settlements in equity markets could also help
reduce lags between those markets and the derivatives markets
-- both exchange and over-the-counter -- thereby reducing the
need for credit on intermarket positions, and making credit
available for other purposes. We've made considerable progress
bridging the time gaps through cross-margin programs -- the
Options Clearing Corporation, as well as various futures
markets, have taken the lead. We ought to take a fresh look
at how these programs work, to see if they can be improved.
* Of course, the collapse of Barings Bank and the demise of
American firms like Kidder Peabody, E.F. Hutton, and Drexel
Burnham Lambert should teach us that regulators and market
participants must remain vigilant to concentrated credit and
market risks. As market participants develop and use
financial products that are difficult to price independently,
they must undertake to keep control procedures current and
maintain a well-trained staff.
* We should not discount the freedom same-day settlement would
give market participants to focus their attention on what they
are doing today and what they want to do tomorrow, instead of
what happened yesterday, or solving problems that arose a few
days ago. It could reduce the number of disagreements over
trades and make those disagreements easier to resolve.
* Finally, same-day settlement offers extraordinary benefits -
- and extraordinary challenges -- in an area of special
concern to all of us: maintaining the pre-eminent role of our
markets in the international arena.
The world economy is becoming more integrated. Foreign
companies continue to look to US markets for capital and liquidity.
103 foreign companies, from 26 countries, entered the United States
public markets for the first time in 1995. At the end of that year,
there were more than 738 foreign companies from 45 countries filing
reports with the SEC. The registered public offerings of foreign
companies amounted to $48.3 billion in 1995.
This has increased the choices available to American
investors, to their benefit. At the same time, American investors
are looking abroad for diversity and growth as never before.
Payment and clearing systems must keep up with this growth.
If US markets are to respond to this interest in foreign stocks
and compete effectively in this area, multi-currency settlement
capabilities must become a reality. All aspects of trading non-
U.S. stocks in U.S. markets, including clearance and settlement,
must be as competitive as other secondary -- if not the primary -
- markets for those stocks.
This will pose a challenge to existing U.S. payment systems,
which today generally do not accommodate non-U.S. currencies. It
will also pose challenges to clearing organizations, their members,
and market participants, to develop the systems and train their
personnel to manage currency risks. If the fine effort at
implementing T+3 is any sort of a guide, we should be up to the
challenge.
I've outlined some of the advantages of speeding up the
settlement process. But faster settlement doesn't come without its
costs -- and not just dollar costs, but practical difficulties that
militate against immediate implementation. I'll focus on just two
of them:
* First, same-day settlement could limit the ability of
individual investors who hold certificates to participate in
securities markets.
The US has the largest number of individual investors
participating in any market. We must be careful not to close the
door on, or somehow alienate, those investors who are our most
important national asset.
Many investors want to be recorded directly with the company
as owners instead of holding stocks in "street name" through their
broker. Many of these direct registered shareholders also want
physical certificates -- as evidence of their ownership, or so they
can have the flexibility to choose among brokers when they wish to
sell.
Our markets draw their strength from being a marketplace for
all. This means we must find ways for those direct-registered,
buy-and-hold investors to access the markets quickly when they want
to buy and sell. This will be challenging, but it can and will be
done.
Broker-dealers have seen a significant increase in the number
of retail accounts and equity holdings for individual investors
during the last few years leading up to T+3. Many brokerage firms
encouraged their customers to leave their securities in street name
because that practice would be more convenient when the investor
wanted to sell. To ward off the overzealous, we asked firms not
to tell their customers that the SEC rule mandating T+3 required
street name holdings.
But even as one segment of the investing public is increasing
its use of broker-dealers, a growing segment is investing directly
with corporate America through direct purchase and dividend
reinvestment programs. Estimates indicate that perhaps 6 million
shareholders participate in dividend reinvestment programs. We face
a challenge in finding ways to connect this segment of the
investing public with existing clearance and settlement systems.
* A second practical difficulty is that same-day settlement
could be expensive for institutional investors and their
agents, who must coordinate their actions.
As you know, institutional investors typically don't engage
the same firms to make investment decisions and to hold their
securities portfolios. This means the typical institutional trade
involves at least three entities: an investment manager who orders
the trade, a broker-dealer who executes the trade, and a securities
custodian to whom the broker-dealer delivers securities or funds.
The institutional experience with T+3 suggests several links in the
chain need to be stronger; for example, settlement instructions
were in place on trade date for fewer than 10% of institutional
trades submitted to the Depository Trust Company in November 1995 -
- the most recent month available. This suggests that much more
needs to be done if we are going to shorten the settlement cycle
beyond T+3.
Some investment managers who serve many clients wait until the
end of the day to inform the broker-dealer of the particular fund
and securities custodian to whom the broker-dealer must deliver
funds or securities. Investment managers who function this way
would have difficulty operating in a same-day settlement
environment.
The answer may well lie in further adaptation of technology
to move information, securities, and funds quickly and safely. The
brokerage industry, the Depository Trust Company, and service
vendors, such as Thomson Financial Services, are exploring ways to
streamline the communication and information management process.
Firms are researching ways to integrate their trader support
systems with their clearance and settlement systems. Firms are
also building standard communication protocols and open electronic
communication systems.
Today, for the first time, these things and more are within
the realm of possibility. Direct registration, home banking,
consolidated asset management, and cybercash are more than just
buzz-words for technophiles. These products are being tested and
perfected in the marketplace. The challenge now is to make these
and other electronic systems reliable through appropriate back-up
facilities and security procedures, so that data cannot be
corrupted, misused, or misappropriated.
If the last 20 years are any indication, security questions
will be resolved, and technology will indeed help us surmount some
of the key obstacles to even faster settlement. But only if our
legal and regulatory structure allows it. There's no way around
it: speedier settlement will require greater integration and
coordination not just among financial firms, but among their
regulators as well. We will need to make a concerted effort to
focus less on turf, and more on common ground.
As a regulator and a participant in the President's Working
Group on Financial Markets, I can vouch for the effective
coordination that has developed among the Commission, the Federal
Reserve Board, the Commodities Futures Trading Commission, the
Treasury Department, and other interested federal bank regulators.
It doesn't take a crisis to bring us together -- we and our staffs
converse regularly on market and interagency concerns. The Working
Group provides a basis for coordination.
I've cited some of the arguments in favor of faster
settlement, as well as some of the obstacles. While I'm not sure
how long it will take to overcome the obstacles, let me leave you
with three steps we can take to lay the foundation for even faster
and safer trading in the next millennium:
* First, we must finish implementing conversion to same-day
funds settlement. Starting in late February 1996, the
securities clearing agencies are planning to stop using checks
in settling payment obligations with their members. This means
trades will be final on "T+3", not the day after, and the
clearing agencies and their members will have to have the
collateral and credit facilities lined up to meet their
expected payment obligations. It will increase the
predictability of settlement, even in high volume, high
volatility markets.
* Second, efficient systems must be built to link direct
registration and securities depositories. Individual
investors should not be forced to choose between registration
with an issuer as a stockholder, and easy access to securities
markets through their broker of choice. If assets must be pre-
positioned, then we should find a way to make the issuer's
share registry one of the locations from which investors can
quickly meet their delivery obligations. I call on brokers,
transfer agents, and corporate secretaries and their
representative organizations to make this a reality, sooner
rather than later.
* Finally, we must improve the technology and process flows for
institutional trading and asset management. We must streamline
-- to one -- the number of times data is entered before a
trade is settled. We must make sure that the information is
secure and promptly communicated to all parties who need to
know it. And we must ascertain that the technology contains
sufficient safeguards to minimize operational failures in the
markets.
System reliability and security will become even more
important as settlement times shorten -- there will be less room
for error, and for breaches of security that could shake investor
confidence in our markets. The Commission has been focusing on the
integrity and reliability of computer systems at the exchanges and
clearing agencies for quite a few years now. We've emphasized the
need to obtain regular, rigorous, and independent assessments of
computer systems. To date our focus has been on the market and
clearing organization system. However, firms and service providers
must also address these issues, both for obvious competitive
reasons as well as for the sake of market integrity.
The three steps I've outlined are not a panacea -- they will
not lead us to the Promised Land of perfect settlement anywhere on
the globe, anytime, in any currency. But together, they constitute
the next horizon along the way. They are logical and realistic
measures that will bring us closer to where I think we all want to
be -- where we all know we ought to be.
It's said that even the longest journey begins with a single
step. When it comes to settlement, I hope that this symposium will
be that step, and that years from now, we'll be able to look back
on these discussions and say that we made a difference.
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